Refining India’s banking system

One of the biggest tasks facing India’s prime minister, Narendra Modi, when he took office was the implementation of a series of much needed reforms to many different facets of Indian life.

In reality, until now, the Modi government has stepped lightly in its reform attempt. But things do appear to be changing. In a long-awaited move, India has begun to implement a series of new banking reforms, including the introduction of the country’s first national bankruptcy law. The impact of these banking reforms will have far reaching implications for the national banking system, particularly at a time when financial institutions, especially public sector banks, are struggling to handle a burgeoning pile of bad loans.

Bankruptcy reform

In May, parliament announced the approval of the Insolvency and Bankruptcy Code, which will make doing business in India easier and will bring an end to a number of pieces of legislation which date back to the colonial era.

The Code will ensure the time-bound settlement of insolvencies, facilitate faster business turnarounds and create a database of serial defaulters. However, the implementation of the Code remains a key issue, since it is predicated on the creation of a complementary ecosystem including insolvency professionals, information utilities and a bankruptcy regulator.

Financial institutions, especially public sector banks, are struggling to handle a burgeoning pile of bad loans.

The new Code will replace existing bankruptcy laws and cover individuals, companies, limited liability partnerships and partnership firms. It will also amend laws including the Companies Act, allowing it to become the overarching legislation dealing with corporate insolvency. It will also help creditors recover loans faster. The introduction of the Code will be a telling moment for India’s banking system, providing a robust and comprehensive legislative framework encompassing a number of different bodies across India.

Bad loans

The Code will take the necessary steps to help overhaul one aspect of the Indian banking regime: the perilous state of the country’s public sector banks (PSBs). Following the nationalisation of India’s banks, 27 PSBs account for 70 percent of all lending. However, many of those banks are in dire straits having lent considerable sums to companies unable to pay them back. Indeed, a remarkable 17 percent of the loans the banks made in 2011 have either had to be written off or are likely to be in the near future. As a result of these defaults, the Indian government and the central bank have begun to tighten the leash on the PSBs.

The scale of the country’s bad loan problem is considerable. According to recent statistics, to the end of March 2016 Indian banks now have close to Rs 600,000 crore in bad loans. As a point of comparison, that is the total asset size of a big lender like Bank of India. This needs to be addressed quickly. The news in early June that India’s banks lost more than $3bn in the second quarter is not only a concern, but also at odds with the 7.9 percent GDP growth the country has experienced of late. Losses of that magnitude are unlikely to be sustainable, and while it is possible that the country’s reasonable economic outlook could help the banks overcome their weaknesses, in the long term it is more likely that the national economy will be adversely affected by its lenders.

The recent announcement by finance minister Arun Jaitley that India would consolidate a number of public sector banks will go a long way to alleviating concerns around the national banking system. According to Mr Jaitley, the number of public sector banks will be reduced from 27 to just 10, a move which will result in improved efficiency, greater economies of scale and enable the country’s larger financial institutions to adapt to the needs of India’s developing economy.

Given the role of larger financial institutions in India’s economy, and the demands placed on those institutions to fund mega-projects like transport infrastructure upgrades, the consolidation of banks into larger blocks makes sense. Smaller banks with lower asset bases could find it difficult to compete with bigger private and public sector banks due to their higher operating costs. Accordingly, the scale achieved in the Indian banking sector through the amalgamation of several smaller banks will generate a number of positives for the Indian economy.

Yet it is important that merging the country’s bigger banks is not seen as a panacea for the wider problems which beset the Indian economy. Larger banks may not necessarily be the answer to the country’s banking problems; existing bigger banks have not been entirely successful to date, hence the need for the programme of reform. Instead, efforts should be made to improve due diligence procedures when issuing loans – the fewer bad loans in the Indian banking system, the better. Equally, efforts should be made to improve the management of existing assets as well as the management of business operations. Recapitalisation is another issue which must be addressed if the Indian banking system is to prosper. The departure of Raghuram Rajan from his position as governor of India’s central bank in September will prove another telling moment in the development of the national economy, given the air of global economic uncertainty. India’s banking system, like much of the national economy, is changing – hopefully for the better.